You know that early preparation and saving are keys to reaching your retirement goals. But if you make six figures, you may have encountered financial hurdles when preparing for retirement. Your relatively high income can actually restrict you from utilizing certain tax-advantaged retirement savings strategies.
Why Are High-Income Earners at a Disadvantage?
The US tax code offers several tax-advantaged retirement savings options, like IRAs and 401(k)s. But most of these options include income limits, making it harder for high earners to take advantage of these tax-saving strategies. Even some employer plans are structured in a way that limits contributions from highly compensated employees.
When it comes to saving enough for retirement, high earners face the same challenge as moderate- to low-income earning employees: sustain a similar lifestyle in retirement by maintaining financial independence. So those earning more than average need to save a similar percentage of their gross income as everyone else, but many may not be able to save nearly as much (as a percentage of their income) in tax-advantaged accounts. This can make reaching their goals for retirement more challenging.
Retirement Saving Strategies
Here are a few things highly compensated employees can do to save for retirement. Focus your attention on the strategies that may work best for you and your family.
Strategy #1: Employer plans
Most employees, even those earning well over six figures, can contribute to an employer plan. So, if you aren’t doing so already, contributing to an employer-sponsored plan is an excellent place to start saving for retirement. You can defer up to $19,500 (or $26,000 if you’re 50 or older) of your pre-tax earnings toward your employer-sponsored 401(k), 403(b), or 457 plan.1 (Other types of employer plans, such as SIMPLE IRAs, may have different limits.)
Many employers will offer matching contributions as well, up to a certain percentage of your own salary deferrals. The employer’s and employee’s combined total contributions for 2021 may not exceed $58,000 (plus an additional $6,500 for those 50 and older) or 100 percent of an employee’s compensation, whichever is lower.
Some plans allow employees to contribute only until their year-to-date earnings reach $290,000.2 (Luckily, this situation is relatively rare. If your contribution is limited by your income, you may want to contact your benefits department to see if they are willing to change the terms of the plan.)
Unfortunately, some employees earning over $130,000 are subject to rules that further limit their contributions.3
As a high earner, your 401(k) will likely offer the highest contribution cap for tax-deferred retirement savings, making it an important cornerstone of your retirement saving strategy.
Strategy #2: Traditional IRAs
A traditional IRA does not have an income limit, which makes it available for high earners. However, you may be limited in how much of your IRA contribution you can deduct on your tax return.
The amount of your deduction will depend primarily on two things:4
- Your modified adjusted gross income
- Whether or not you have access to an employer-sponsored retirement plan, such as a 401(k)
This means that traditional IRAs on their own are not always a great option for high earners. But they can be used in backdoor Roth IRA strategies (see below).
Strategy #3: Backdoor Roth IRAs
Roth IRAs allow retirees to make tax-free withdrawals in retirement, meaning they can appeal to those saving for retirement. Unfortunately, it may not be an option for some high earners. If your modified adjusted gross income is between $125,000 and $140,000 as a single filer or $198,000 and $208,000 as a joint filer, you may be eligible to contribute a reduced amount to a Roth IRA. But above those limits, contributions are not allowed.5
However, those who aren’t eligible to contribute to a Roth IRA may benefit from a much-discussed alternative called a backdoor Roth IRA. As the name suggests, this strategy offers high-income earners a roundabout way to put their after-tax dollars into a Roth IRA account:
- Open and contribute to a traditional IRA account, where there is no income limit.
- Then convert your traditional account into a Roth IRA.
- Pay income taxes on any gains the account may have incurred before the conversion.
This strategy works best for those who do not already have a traditional IRA with contributions that were deducted in a previous year.
If this sounds like an option you may be interested in pursuing, your financial advisor or CPA can offer more guidance and instruction.
Strategy #4: Taxable Brokerage Accounts
For many high earners, contributing the maximum to their retirement account still leaves them shy of their savings goals. They may feel that they are saving adequately because they have contributed all they can to retirement accounts. But if you are saving the maximum in your employer plans and IRAs, you should calculate whether that’s a large enough percentage to meet your goals (frequently 10%-15%). If not, you should contribute to a taxable brokerage account as well.
When contributing to a brokerage account, we recommend either setting up automatic monthly deposits or contributing a set percentage of your income. It is also important that you mentally designate this as a retirement account, not money available for splurges or other purposes.
If you’re earning six figures or more, it may be helpful to work with a financial advisor who can help you understand your savings options. Whatever strategy you choose, be sure to stay up-to-date on contribution limits and eligibility requirements. This can help you and your retirement savings avoid any surprise tax bills now or as you approach retirement.
Concerned about saving enough for retirement? Schedule a free phone consultation with us today.
This content is developed from sources believed to be providing accurate information and is provided at least in part by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Original content of Practical Financial Planning, Inc. only is copyright © 2021 by Practical Financial Planning, Inc.